James Bevan: Beneath the surface of declining oil prices

The received wisdom is that the recent decline in oil and other commodity prices should provide a boost to global growth by increasing household real incomes in countries such as the US, and most of all in the oil-importing industrial economies. Many analysts are likening the fall in oil prices to a ‘tax cut’ for oil consumers, although it is also akin to a tax hike for oil producers, and a number of recent reports from the oil industry and some US credit analysts have suggested that at the current oil price the US will not drill any more wells for the foreseeable future, and at a sub $60 oil price, some wells may be uneconomical. This will be troublesome for their owners, their employees (including those in the support industries), and the owners of the ‘junk bonds’ that were issued to finance the drilling of these wells.

Digging in to the details, on the income front, the US employment data show the drilling and associated services industry as responsible for about 2.3% of total employment growth in the US over the last year and almost 3% of the growth in total wage incomes received by US households. Therefore, it seems likely that if oil prices remain at current levels, then the US household sector could experience nominal aggregate incomes perhaps as much as 15-20 basis points lower than it might have been had oil prices stayed at a higher level. On the expenditure side, US household spending on energy products amounts to around 4% of total spending, which suggests that the household sector in aggregate will likely receive a net direct benefit of c.120 basis to its effective real incomes from the fall in oil prices, and in net terms therefore aggregate household real incomes may be around 1% higher next year as a result of the decline in the oil price.

At first sight, this looks very useful but we don’t really know what households will do given that when households faced a decline in effective real incomes when energy prices rose a few years ago, they borrowed more/saved less and therefore conceivably could decide to respond to lower energy prices by saving more now.

There are added wrinkles to consider. Thus increases in non-energy related spending, such as retail sales, but perhaps also including spending on non-GDP creating assets such as existing homes and other assets, are really just substitutes for spending on energy, and to understand the impact on an economy of different spending patterns we need to know the import/export implications and what the recipient of the money spent then does with the money received. Fiddling with these parameters suggests that the net direct benefit to US consumer spending from the fall in the oil price could be no more than half a percent of GDP and quite possibly as little as 25bp +/- 15bp. This is useful but certainly not a game-changer.

More broadly, if lower oil prices trigger an increase in investment intentions outside the oil sector (and the latest small company business survey suggest that this might be so), then the household sector, and by implication the whole economy, will likely also be a net indirect beneficiary from the lower oil prices – but this isn’t easy to assess and isn’t a certainty.

Elsewhere within the global economy, with Japan, the fall in oil prices has prevented the country’s terms of trade from deteriorating further as the Yen has weakened – Japan’s terms of trade haven’t improved despite the lower oil price simply because Japan’s export prices have declined with the JPY, at the same time as the lower oil price has helped to reduce the country’s oil import bill.

With Korea and perhaps China, the fall in the oil price has led to a useful improvement in terms of trade but this does not seem to have boosted business confidence, while with Australia, both business and consumer confidence seem to have weakened along with oil prices.

Over in Europe, the fall in the oil price in Euro terms will support effective household net incomes, although uncertainties remain about energy supplies from Russia and even refining capacity in the UK, and the fall in the oil price may further raise expectations of deflation in the region, which could lessen the net benefit of the fall in prices. Frankly it’s impossible to tell the trade-off between the income benefit and more deflation risk, and we do know that the North Sea hydro-carbon producers will suffer a notable loss in incomes. However, on balance Euroland should be a net beneficiary, and probably on the roughly the same terms as the US.

Turning to the oil producing countries in the round, the fall in oil prices affects export revenues, balance of payments conditions and even by implication domestic credit conditions, with weaker balance of payments positions tending to place downward pressure on credit conditions. The net result will be that growth rates will probably slow. This will affect not only those countries directly concerned but also a range of connected economies and not always very obviously. Thus, the Philippines may lose from the fall in oil prices given its large trade and repatriated income links with the Gulf economies. Given the inter-connectivity of economies, the ‘multiplier’ effects or collateral damage from the fall in oil prices should not be understated.

Falls in oil and other commodity prices may also have policy implications for some of producer states. For example, Chile has adjusted well to lower commodity prices, but at the cost of supressing domestic demand, and oil producing economies may choose or need to follow Chile’s example, with Russia particularly stressed by the combination of lower oil prices and sanctions.

Overall, we have a picture that reveals that the fall in the oil price may not be a universal benefit and may instead be more like a zero sum game not just for the global economy, but even for some of the supposed beneficiaries and thus far there are relatively few countries that have reported terms of trade benefits from falling energy prices.

Taking a broader view of developments, we may suspect that the fall in the oil price is not so much due to specific factors such as OPEC weakness or a rise in non-OPEC production, but is more the result of a generalized deflationary environment within the global trading system, caused by or associated with closure of Developed Market current account deficits and the re-widening of North Asian surpluses, in both cases via the inherently deflationary route of weak import trends. Thus closure of Developed Markets’ current account deficits and revival of Asian surpluses over recent months implies that other countries must have experienced a deterioration of their current accounts, with commodity producers suffering.

The conclusion that commodity price weakness is the result of improving current account balances of both Developed Markets and North Asia, connected to the intransigence of governments rather than just their central banks, does at least mean that weakness in commodity prices does not seem to reflect further weakness of the global economy – and indeed there are few signs that conditions have deteriorated since the summer.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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